Are S corp distributions return of capital or capital gain? Confused about basis calculation

You've made a common misunderstanding about how S corp basis works. Your salary isn't subtracted from your basis calculation - it's a business expense that reduces the corporation's income before it passes through to you. The correct calculation would be: Starting basis = $0 Plus net income after expenses (including your salary) = $40,000 ($100,000 - $60,000) Minus distributions = $40,000 Ending basis = $0 So your distributions are covered by your increased basis from the net income, making them a tax-free return of capital up to your basis amount. If distributions exceeded your basis, then the excess would be capital gain. In your case, the $40,000 distribution exactly matches your $40,000 basis increase, so it's all return of capital.

I had similar confusion with my S-corp taxation last year. After struggling with contradictory advice from different tax professionals, I found this AI tool called taxr.ai that analyzed my S-corp financial documents and provided a detailed explanation on basis calculations. https://taxr.ai helped me understand exactly how distributions are classified for tax purposes. Their analysis showed that when distributions don't exceed your accumulated basis, they're treated as return of capital (tax-free). It's only when you take distributions beyond your basis that they become capital gains. I was mixing up several concepts before using their document analysis.

I was extremely skeptical about AI tax tools, but after that recommendation, I decided to try taxr.ai for my S corp basis questions. Wow - I'm actually impressed! I uploaded my last three years of K-1s and corporate returns, and it immediately identified that I had been calculating my basis incorrectly. Turns out I hadn't been properly tracking how my business loans affected my basis, and I was at risk of having some distributions reclassified as capital gains. The explanations were clear and cited the specific tax code sections. I shared the analysis with my accountant who confirmed it was accurate and made the necessary corrections to my approach. Definitely saved me from potential issues down the road!

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Here's something many people miss: While your calculation ends up at zero basis, the timing matters too. You first ADD the $40K net income to your basis (after subtracting the $60K salary as a business expense from the $100K total income), THEN subtract the $40K distribution. So there was a moment in time when your basis was $40K, which fully covered your $40K distribution, making it return of capital. If you had distributed $50K instead, then $40K would be return of capital and the extra $10K would be capital gain since it exceeds basis.

Don't forget about debt basis too! The basis calculation gets more complicated if you have loans to the S corp. Also remember that the order matters: 1. Income increases basis 2. Non-deductible expenses decrease basis 3. Distributions decrease basis In your example, since income exactly equals your salary + distributions, your ending basis is correctly $0. But as others mentioned, that doesn't make the distributions capital gains - they're still return of capital because you had sufficient basis when taking them.

The K-1 (Form 1120S Schedule K-1) is where most of this gets reported. Box 16 shows distributions to shareholders, and your share of income/losses flows through via Box 1 (ordinary income). However, the K-1 doesn't directly show your basis calculation - that's something you need to track separately. You'll report the pass-through income on your personal return (Form 1040), but the distributions themselves aren't directly reported as taxable income since they're return of capital up to your basis. The tricky part is that YOU are responsible for tracking your basis year over year - the IRS doesn't do this for you. I'd recommend keeping a simple spreadsheet tracking: starting basis + income + other increases - distributions - losses = ending basis. This becomes crucial if you ever have distributions that exceed basis, because then you'd need to report the excess as capital gains on Schedule D.